10/13/2009 @ 6:00AM

Saving The Union (Pacific)

On the fringe of Council Bluffs, Iowa, where the windows are cracked and rust clings to the hubcaps of dilapidated Cadillacs, the future of American railroading thrums at idle, part of a billion-dollar shotgun wedding between
Union Pacific
and the world’s most advanced train-control system.

At 200 tons and 4,400 horsepower, the $2 million
General Electric
-built locomotive sitting in an oversized garage represents the consummation of that relationship, thanks to its gleaming, GPS-enabled guts. Chief Executive James Young has spent the past year revving up a GPS refit of his company’s 6,000 locomotives at a cost of $60,000 apiece. Concurrently, the company is beefing up signal capacity along 32,000 miles of track as part of a $1.4 billion total outlay. The vast new system will pinpoint a locomotive’s location within one yard, improving safety and fuel efficiency.

It’s an expensive job–especially in lean times–but Young didn’t have a choice. After a Los Angeles commuter train collided head-on with a
Union Pacific
locomotive in September 2008, killing 26 people, Congress passed the Rail Safety Improvement Act of 2008, which required Union Pacific and the other major railroads to implement a new train control system by December 31, 2015. For Union Pacific, the world’s largest railroad, that means refitting an average of 2.5 locomotives, 10 wayside interfaces and 10 miles of track every day for the next seven years.

Last fall, as diesel prices approached $5 per gallon, the mandate didn’t look so onerous. Union Pacific consumed 1.2 billion gallons of diesel in 2008, second only to the U.S. Navy. Initial estimates of the new system suggested it could cut the company’s fuel consumption by as much as 8%, which would translate to half a billion dollars in annual savings, in addition to the important safety improvements.

Then the global trade bonanza ground to a halt, customers dried up and diesel dipped toward $2 a gallon. “I now have a billion-dollar unfunded mandate–that bothers me,” says Young. “Everything has to be right for this project to make financial sense.” Based on current fuel prices, the opposite is happening. The Federal Railroad Administration estimates that the new system will cost the railroad industry $10 billion and return just $650 million.

Union Pacific reported a 22% decline in carloadings in the second quarter; revenues fell 28% to $3.3 billion, slightly worse than Burlington Northern’s 26% decline. Young has mothballed 1,900 locomotives and furloughed 4,400 employees to compensate. Starting in September 2008, Union Pacific’s stock plunged 60% over six months, and now trades at 14 times earnings. It’s bad, but on par with sector peers.

Still, says Kevin Kirkeby, a railroad analyst at Standard & Poor’s, “he seems to have been more willing than other rail managers to really take out costs. It sets the stage for what we expect would be some major efficiency gains as volumes come back on the rails.”

Some of that’s happened already, with average train speed up 20% to 27.4 miles per hour in the second quarter. Young is also hoarding cash: his company holds $1.7 billion on its balance sheet, nearly double the $611 million year it had a year ago.

What’s more, Young has been aggressively wooing customers, especially in the lucrative premium cargo category. This includes hauling new autos, hazardous chemicals, and other high-margin products in specialty train cars. In June, Union Pacific lured logistics outfit
Hub Group
away from Burlington Northern. Union Pacific now gets an average of $1,755 per carloading, 11% more than Burlington Northern’s $1,576. That should put Union Pacific in the engineer’s seat when things turn around, says Kirkeby.

Young is used to tough gigs. The oldest of six children from a working-class Omaha family, he spent seven years getting through college, working odd jobs to pay tuition. He joined Union Pacific in 1978, accepting the offer just days before a position opened up at his first choice, Northern Natural Gas. (The company later went on to become part of Enron.)

After working his way through the ranks at Union Pacific, Young was elected chief in November 2005. He inherited a lumbering giant plagued by overcapacity, sloppy service and an unwieldy acquisition–six years earlier, Union Pacific had finally succeeded in buying rival Southern Pacific, a deal the company had originally completed in 1901, only to see it reversed by a monopoly-fearing Supreme Court in 1913. When the deal was reconstituted almost a century later, the troubled remnants of Southern Pacific weighed down Union Pacific’s balance sheet for years. The year Young took over, earnings were down 29% to $600 million, while profit margins had fallen to an industry-worst 6%.

Young also got tough with customers. When one factory lagged unloading a 130-car coal train, he pushed its managers to work Saturdays so that his trains wouldn’t sit unused all weekend. Young told foreign shippers making deliveries at West Coast ports that his trains would leave without them if shipments didn’t arrive on time. Margins now stand at 22.7%.

“Jim Young is one of the best managers that I’ve met with,” says Tom Marsico, owner of Marsico Capital. “In the past, people were afraid to say no to customers.” Young demurs. “I’m no Attila the Hun,” he says. “But we did demand a culture of service, which was not always at the top of the list.”

In addition to standing up to deadbeat customers, Young championed Union Pacific’s Fuel Masters Program, an employee-driven initiative that rewards the most efficient engineers with debit cards they can use to fill up their own vehicles.

Indeed, Union Pacific has a few trends working in its favor. Trucking companies’ market share of domestic shipping has been stalled at 30% for the past decade, while rail shipping is up from 38% to 43%. Manufacturers have taken note that, based on gross ton miles, trains can carry a ton of freight 830 miles on a single gallon of fuel; trucks stretch a gallon only 200 miles.

With diesel prices up 30% from five-year lows in March, it seems cheap fuel may not be around much longer. If it ever returns to last summer’s levels, the mandate–now just a year old–could still pay off.